10 February 2023 |

The Real Reason Most VC’s Incubate Companies


Ian’s Note: If incubation and working with Vol. 1 Ventures sounds interesting to you after reading this, shoot me a note by replying to this email!

Over the past few months we’ve been working on building an incubation program at Vol. 1 Ventures, and have been working with a few companies we hope to spin out from the fund in a year or so.

So far, Stevie and I have learned a few things:

Incubation is fun!

Incubation is fucking hard!

Incubation isn’t for everyone.

At the core of it, incubation is essentially when a firm provides services and value to founders or newly minted companies in exchange for preferential terms. There isn’t a standard definition—lots of folks call YCombinator an incubator (its not, its an accelerator), and a lot of VC’s say they incubate companies when they just write early checks. Just like everything else in VC, its hard to find some standardization.

At Vol. 1 Ventures, we define an incubated company as one that was “started at the fund.” You might be an analyst or engineer at the fund and have a really good idea that we’ll let you work on part time. Or you might be someone close to the Vol. 1 ecosystem that wants to start a company and we figure out a business that’s ideal for your skillset, experience, and interests. Essentially, incubation to us is the closest a VC firm can and should get to company creation within their firm.

(FYI, the next stage up is “acceleration,” which is YC and the like, and is usually post-idea.)

If this sounds a lot like an EIR role, its because its very similar, by design. Stevie and I both were approached for a few Entrepreneur in Resident roles over the past 3 years, which is basically a role paid for by a fund in exchange for a predetermined amount of equity in any company created by the individual.

But to me, EIR roles seem particularly exploitative—a VC can get anywhere from 20-40% of a company in exchange for 1 check leading a preseed round. To me, as an ex founder, it feels like I’d be working for a VC with very little upside—if I sell 40% of a company by the preseed or seed round, what am I or employees and other VC’s left with by the Series C round?

From what we can tell, most funds that incubate do so extremely secretively, with a close network of collaborators, and seem much more focused on getting access to companies early rather than funding businesses. This creates an environment where VC’s can be a bit shady—I’ve heard about fintech VC’s taking pitches from fintech companies, while an EIR is making a similar competitor internally.

For the last 5-10 years, one could argue that much of a VC’s role has been focused on sourcing deals and getting as much allocation as early as possible. That’s made them very good at a few things—negotiating against early stage founders for instance—but that create misaligned incentives between an investor and a founder. A good rule of thumb: any time you’re an investor and you think “oh damn I really screwed that founder good,” you’re probably making a mistake.

Incubation came up as a solution where VC’s can partner and work with really great operators early and get a huge chunk of the company early. The VC’s incentivized to have this be a win because they own such a big chunk for usually low amounts of capital at cheap prices.

To us, incubation solves an innovation problem: how do we create meaningful and transformative companies in regulated sectors?” VC’s are usually happy to invest in a company that looks like something else: Plaid for Latin America, or Mercury for India. And honestly nothing against these ideas—I’m sure they are solid businesses with decent exit potential and hypothetical returns for a fund. But at Vol. 1 Ventures, we don’t want to back companies that are incrementally better than their competitors—we look for companies that create step function shifts in the world.

Our biggest issue? This is especially hard with startups in regulated sectors—that take a lot longer to build, a lot longer to go to market, and a lot longer to exit (if you think fintech is bad, wait till you hear about healthcare.) With such narrow search parameters, its hard to find the right founder with the right idea in a regulated sector that we’re bullish in.

So, incubation solves that for us. We can spend a lot of time honing and cultivating our domain expertise—in regulation and compliance, in different ecosystems and domains like fintech & crypto, and in tactical operations like going to market or building a brand. We can focus on thinking about different businesses that should exist in the world and understand why they aren’t. And, if we find someone in our network that’s excited by the idea too, we can see if it makes sense to spin out into a separate company.

At the end of the day, we’re not aiming to incubate companies for purely a financial gain. We’re incubating companies to create the change we hope to see in a more fair and equal world.

I have only so much room to write here but I left a lot out—how we think about different problem areas to research, how we want to vet and validate different ideas, and more. If you’re looking to learn more, feel free to reply to this email!